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City of Swan v Lehman Brothers: deed of company arrangements and third party releases

The High Court of Australia is expected soon to hand down its judgment in Lehman Brothers v City of Swan. It is likely that this judgment will definitively determine whether Deeds of Company Arrangement under Pt 5.3A of the Corporations Act (“the Act”) are able to force creditors to give releases to third parties.

On 15 September 2008 Lehman Brothers Holdings Inc (“Lehman Inc”) filed for Chapter 11 Bankruptcy in the US. On 17 September 2008, Lehman Brothers Asia Holdings Limited (“Lehman Asia”) followed suit and appointed provisional liquidators. Then on 26 September 2008 Voluntary Administrators were appointed to Lehman Brothers Australia Limited (“Lehman Australia”). At the second meeting of creditors, the creditors voted in favour of executing the Deed of Company Arrangement (“DOCA”); 61 ($256 million in value) to 58 ($72 million in value). The DOCA was executed on 12 June 2009.

Prior to entering into external administration, Lehman Australia sold Collaterised Debt Obligations (“CDOs”) to the plaintiffs all of which are Local Government councils. It is that act which has lead to potential claims against entities related to Lehman Australia (“Lehman Entities”), and it is those claims that are the subject of the third party releases. Clause 11 of the DOCA provides:

“On payment in full of the Litigation Creditor’s Final Dividend all Claims by the Litigation Creditors [including the plaintiffs] against the Company or a Lehman Entity and all Insurance Claims except those that arise out of the Preserved Contractual Rights are, for ever released discharged and extinguished.”

The Full Court was asked, in essence, to determine firstly whether the DOCA seeks to extinguish the plaintiffs’ claims against Lehman Entities; and secondly, if it does, whether there is power under Pt 5.3A of the Act to include such provisions.

Power and Validity

Subsection 444D(1) of the Act provides:

“A deed of company arrangement binds all creditors of the company so far as concerns claims arising on or before the day specified in the deed under paragraph 444A(4)(i).”

It is this section which gives a DOCA its binding force. The defendants submitted that pursuant to this section, the DOCA bound creditors in respect of their claims against the company, insurers, other creditors and other third parties.

Justices Stone, Rares and Perram all held that properly construed this subsection does not allow a DOCA to deprive nonconsenting creditors of their rights to sue third parties. In holding that a DOCA of itself cannot provide for third party releases, each member of the Full Court employed differing reasoning, yet each shared elements of commonality. Each judge discussed the expression “so far as concerns”, and sections 444A, 435A, and 444J. Justices Rares and Perram both also discussed the decision in Fowler v Lindholm and its relevance to Pt 5.3A.

“so far as concerns”

The fourth defendant submitted that “”so far as concerns” meant “relating to”, “connected with”, “being of interest or importance” or “affecting” claims against the company” and that therefore subsection 444D(1), properly construed, binds creditors in respect of their claims that have a nexus with the company.

There are a number of previous judicial decisions regarding section 444D(1) however, as Justice Stone pointed out in her judgment, these decisions neither deal with the phrase “so far as concerns” or “go so far as to read the section as referring only to claims against the company”. Justices Stone and Perram explicitly, and Justice Rares implicitly, considered that the phrase “so far as concerns” was ambiguous, in that it was capable of meaning those phrases referred to above, and also of the more restrictive interpretation proffered by the plaintiffs, namely that it relates only to claims against the company.

Both Justices Stone and Rares referred to the “basic” principle of statutory construction namely that without “clear words that are not capable of another construction”, a statute should not be interpreted as interfering with the property rights of an individual. It is clear that the third party releases provided under the DOCA sought to interfere with the plaintiffs’ property rights pertaining to potential claims against those parties. Accordingly Justice Rares held, because “no express words in Pt 5.3A support”, the broad interpretation submitted by the defendants and this interpretation interferes with existing property rights, it must be rejected. Interestingly, Justice Stone went further to suggest that this principle applies to any “existing” right, but ultimately held that “although this principle still has life it is not … necessary to rely on it.”

Sections 444A, 435A and 444J

Given the reference to section 444A in section 444D, it is unsurprising that each of the judgments refer to section 444A. In fact Justice Rares went so far as to state that: “The significance of the provision of s 444A(4) (b) and (i) in the construction of 444D(a) is obvious.” His Honour then went on to hold that:

“The literal, grammatical, and common sense construction of s 444D(1) is that it refers to claims of creditors corresponding to those referred to in s 444A(4)(b) and (i)…”

Justice Stone also considered these provisions relevant and that “claims” in the context of section 444A(4)(b) and (i) “clearly refers to claims against the company”. Justice Stone further considered that the fact that in section 444A, and indeed throughout Pt 5.3A, “creditors are referred to in their capacity of creditors of the company”. Justice Perram similarly held that the construction proffered by the defendants does not sit comfortably with the reference to 444A(4)(i) in 444D(1).

All three judges considered that the objective of Pt 5.3 A, to provide for the business, property and affairs of an insolvent company, was relevant to the construction of 444D(1). Justice Rares held that, at a minimum, this objective is not reflective of Parliament intending a DOCA to permit the majority of creditors to deprive a minority of any rights or claims they might have against entities other than the company in administration. Justice Stone further held that given this objective, section 444D should be construed as referring to the claims of the creditors against the company. Justice Perram, by contrast, held that at a high level of abstraction, minds could legitimately differ as to the effect of section 435A on the construction of section 444D.

A similar point of difference in the judgements of Justices Stone and Perram is found in their discussion of the influence and effect of section 444J, which provides that guarantees and indemnities are not affected by the release provided in section 444H in respect of DOCAs. This section was introduced following the decision in M & S Bulter Investments Pty Ltd v Granny May’s Franchising Pty Ltd. In that decision, Justice Spender held that a DOCA “can only deal with company property.” Justice Stone held the enactment of section 444J does not adversely affect Justices Spender’s judgment, but rather supports it. Conversely Justice Perram held that section 444J ‘merely ensures that a guarantor is not released’ because the principle debtor is released; he did not discuss Justice Spender’s decision.

Fowler v Lindholm

Justices Rares and Perram held that the Full Court of the Federal Court decision in Fowler v Lindholm was not relevant to the operation of Pt 5.3A. Fowler v Lindholm was heard on 3 and 4 September 2009 and the joint judgment of Justices Emmett, Gordon and Jagot was delivered three weeks prior to judgment being delivered in City of Swan v Lehman Australia. In Fowler v Lindholm the Court held that in relation to schemes of arrangement under Pt 5.1 of the Act, “...the Court had power to approve the Schemes containing the provision for release and indemnity [of third parties].”

At first glance the two judgments appear to be disharmonious. The following facts are common to both matters:

the plaintiff was an investor

the entity through which the plaintiff invested had become insolvent

the scheme of arrangement or DOCA was entered into as a result of the entities insolvency

the claims which were the subject of the release related to the plaintiff’s investment

the release was to a third party

the plaintiff did not consent to the release.

In considering the relevance of the judicial interpretation of Pt 5.1 to Pt 5.3A of the Act, Justice Perram focussed upon what Parliament intended by the language it has used in Pt 5.3A. He held that in 1992, when Pt 5.3A was introduced, the state of the law in relation to third party releases under Pt 5.1 was uncertain.

Ultimately, Justice Perram held that Fowler v Lindholm was not relevant to his judgment because the question was whether, at the time of enacting Pt 5.3A, Parliament knew that third party releases were available under Pt 5.1 and therefore whether it was intended, by its use of the word “arrangement”, to import that scope to Pt 5.3A.

Although, ultimately holding that what is achievable through Pt 5.1 schemes of arrangement “does not bear on the construction of Pt 5.3A”, Justice Rares criticised the Court’s judgment in Fowler v Lindholm’s for not referring to “the basic principles of statutory construction”.

Justice Stone did not expressly discuss the decision in Fowler v Lindholm. She did however note that in light of the substantial judicial supervision which is necessary under Pt 5.1, but not Pt 5.3A, it was unsurprising that there is more scope as to what can be achieved under Pt 5.1 than Pt 5.3A.

Despite appearances to the contrary, it is possible for the decisions in City of Swan v Lehman Brothers, and Fowler v Lindholm to exist harmoniously. The answer might lie in reliance upon the court’s supervisory functions in relation to Pt 5.1 and in particular those sections relating to the voting procedures. None of the judges in City of Swan v Lehman Brothers referred to the differences in voting procedure between Pts 5.1 and 5.3A of the Act. The two most important of these are:

In order to pass a resolution to enter a creditor’s scheme of arrangement, the consent of the majority in number of creditors and 75 percent in value is needed, whereas to enter a DOCA, all that is required is the consent of a majority in number and value.

Under Pt 5.1, but not Pt 5.3A, the creditors can be divided into classes for the purposes of voting.

It is also important to note that in respect of Pt 5.1, the court has a supervisory role both prior to the meeting in approving or refusing the scheme of arrangement as passed by the creditors. Accordingly, it is possible to structure the voting procedure at a meeting of creditors held under Pt 5.1 so that those creditors who are asked to provide third party releases under the scheme vote as one class. In order to pass a resolution approving the scheme of arrangement, it would therefore be necessary to gain the consent of at least the majority in number and 75 percent in value of the creditors who are asked to forfeit their rights and claims against the third parties. This construction could arguably lead to a situation where a creditor is deprived of its rights in relation to a third party pursuant to a scheme of company arrangement, but would not have been deprived of these rights under a DOCA.

There are a number of conclusions open to the High Court. In relation to the power contained in section 444D, the Court could decide that a DOCA is capable of providing for third party releases. It could agree with the Full Court in City of Swan v Lehman Brothers that section 444D does not permit a majority of creditors, pursuant to a DOCA, to deprive the minority of their rights and claims against third parties. In deciding in this manner, it could disapprove of the judgment in Fowler v Lindholm or explain by reference to the differences in judicial supervision and voting procedures how the two principles are able to co-exist. It is anticipated that whatever the outcome of the appeal in City of Swan v Lehman Brothers, the judgment of the High Court will discuss the decision in Fowler v Lindholm and set guidelines for the future of third party releases in creditor’s schemes of arrangement and deeds of company arrangement.

Piper Alderman’s Amanda Banton acts for the plaintiffs in these proceedings.

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